Alternative Investment Management Association Representing the global hedge fund industry
DMS Offshore Investment Services
The Securities and Exchange Commission (SEC) has set sail for the Cayman Islands, embarking on a new expansion of its authority that could have a significant impact on hedge fund managers with offshore operations frequently accessing the U.S. market. A cooperative agreement that the SEC struck with the Cayman Islands Monetary Authority (CIMA) in March 2012 promises to give the U.S. agency a new window into Cayman based operations. Exactly how U.S. regulators will employ this new tool, or how much access Cayman Islands regulators will allow, remains to be seen.
However, a significant number of hedge fund managers with Cayman funds or management companies may now find that some previously held private information on those operations could be shared with U.S. regulators. This prospect has generated some concern and unease among managers who might be affected. While the two regulators have a history of working collaboratively together, the measure clearly is not benign and has the potential to be substantial. It fits with the SEC’s ongoing effort to more closely monitor and regulate hedge fund activities and represents an interest by the SEC in expanding its oversight to foreign locations that hold assets on behalf of U.S. investors or frequently access the U.S. market.
Since the financial meltdown, the hedge fund industry has unquestionably become a top priority of the SEC, with unprecedented resources being allocated to the SEC's Asset Management Unit to actively pursue hedge fund issues and conduct examinations. The Cayman Islands are an important link in the SEC’s goal of following the money through its regulatory efforts. In striking the deal with CIMA, the SEC sets an important precedent in its ability to track and monitor these assets in Cayman hedge funds.
While managers may not like it, many investors - particularly institutional investors - may take a more positive view of the agreement. Hedge funds have become increasingly tied to institutional assets, and it is precisely those investors who demand increased oversight, transparency and governance. As representatives of firemen, teachers, universities and hospitals, institutional investors such as pension plans might well feel comforted by the introduction of the SEC window into Cayman Island funds. While managers may initially foresee increased cost and effort associated with the agreement, they may later discover that their hedge funds become more attractive to institutional investors such as pension plans with additional capital available to allocate due to SEC access to the offshore arena.
So what can managers expect from the cooperation agreement and what can they do now to prepare for it?
It is still early in the process to know precisely how this will work and how each regulator will interpret their roles and obligations. But in its comments upon release of the agreement, the SEC laid out some of the basic principles behind the deal. The SEC has been working under cooperative agreements, called memoranda of understanding (MOUs), with foreign entities since the 1980s, starting with pacts allowing regulators to share information in specific cases involving securities enforcement actions. The SEC now has 80 of those enforcement-related agreements in place around the globe. The new MOU with CIMA is part of an effort to expand SEC oversight. The agency is seeking to go beyond general oversight of its US regulated asset managers and funds and also gain information access to non-US based managers or funds who, while not based stateside, still have the potential to impact the US.
As the SEC explained in a 23 March 2012 release on the Cayman agreement: “Such information may include routine supervisory information as well as the types of information regulators need to monitor risk concentrations, identify emerging systemic risks, and better understand a globally-active regulated entity’s compliance culture. These MOUs also facilitate the ability of the SEC and its counterparts to conduct on-site examinations of registered entities located abroad.” With that last line, the SEC has put US and non-US fund managers on notice that its agents are now equipped to make on-site inspections of Cayman Island operations. In addition to the ability to make its own inspections, the second matter to prepare for is that the SEC also may now have access to information collected from Cayman Islands domiciled investment managers or funds. Information CIMA collects such as financial statements and Fund Annual Reports (FAR) which is similar to the SEC's Form PF. This information gives insights into portfolio construction, fund expenses and operational details previously not available to the US regulator.
With the introduction of this agreement, once again fund governance is placed in the spotlight. Fund governance intersects all of the SEC's focal points, including valuation, custody, expenses and conflicts of interests (especially those relating to liquidity management mechanisms). Therefore, expect fund governance to emerge as a key focus during potential SEC examinations. To prepare, Cayman-domiciled funds would do well to adopt institutional-quality fund governance practices that meet the agency's regulatory standards released in 2004.
Another matter for consideration is to assess the benefit of moving towards a uniform approach to fund governance practices across the entire fund complex rather than using one set of governance standards for the U.S. fund and another for the offshore fund.
The agreement's message is clear. The U.S. regulator is positioning itself to gain more access to information on Cayman Islands based operations and will take the lead in establishing global standards for hedge funds. Stakeholders should take notice and expect scrutiny to intensify.
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